SurModics' CEO Discusses F3Q12 Results - Earnings Call Transcript

| About: Surmodics, Inc. (SRDX)
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SurModics, Inc. (NASDAQ:SRDX) F3Q12 (Qtr End 06/30/2012) Earnings Call August 1, 2012 5:00 PM ET


Tim Arens - VP and Interim CFO

Gary Maharaj - CEO


Ross Taylor - C.L. King

Beth Lilly - GAMCO Investors

Gregory Macosko - Lord Abbett

Jeffrey Warshauer - Sidoti & Company


Welcome to the SurModics third quarter 2012 earnings conference call. (Operator Instructions) I would now like to turn the conference over to our host, Mr. Tim Arens, Vice President and Interim Chief Financial Officer.

Tim Arens

Good afternoon. And welcome to SurModics' fiscal 2012 third quarter earnings call. Also with me on the call is Gary Maharaj, our Chief Executive Officer.

Our press release reporting our full third quarter results was issued earlier this afternoon and is available on our website at Also issued earlier this afternoon was our press release announcement plan to launch a tender offer to purchase up to $55 million of SurModics common stock. Details related to the tender offer will be set forth in our offer to purchase, which will be filed with the Securities and Exchange Commission.

Before we begin, it is my duty to inform you that this conference call is being webcast and is accessible through the Investor Relation section of the SurModics' website, where the audio recording of the webcast will also be archived for future reference.

I will remind you that some of the statements made during this call may be considered forward-looking. The 10-K for fiscal year 2011 identified certain factors that could cause the company's actual results to differ materially from those projected in any forward-looking statements made during this call. The company does not undertake any duty to update any forward-looking statements as a result of new information or future events or developments.

On today's call, I will provide an overview of our financial results, highlights for the quarter and an update outlook for fiscal 2012. Gary will then discuss our key achievements for the quarter and provide an update on our growth drivers and strategies, including additional detail on our plans to launch a tender offer to purchase up to $55 million of our common stock. Following this discussion, we will open the call to take your questions.

Unless otherwise noted, third quarter financial results discussed today exclude the $112,000 third quarter loss associated with discontinued operations. Thus, the financial information that I discuss relates to our continuing operations and as in many cases on a non-GAAP basis.

As in past quarter's, I'll provide insights and performance comparisons, excluding the financial impact related to the discontinuation of Cordis' Cypher and Cypher Select Plus drug-eluting stents.

You will recall that in prior periods, we have generated both product and royalty revenue based on sales of these Cordis products, which have incorporated our proprietary drug delivery and hydrophilic coating technologies.

Our earnings announcement issued earlier this afternoon provide supplemental non-GAAP financial information that adjust for Cypher and certain events specific charges. We believe that these adjustments provide meaningful insight into our core operating performance in an alternative perspective of our operating results.

It is worth noting, that beginning with Q1 of fiscal 2013, the discontinuation of these Cordis products will no longer have a meaningful impact on our comparative numbers.

Our financial performance excluding Cypher resulted in strong revenue growth, while our core business has generated record operating income during the quarter. Revenue for the third quarter totaled $14 million, which is up 7% from the $13 million reported in the third quarter of last year.

On a comparative basis, our third quarter revenue growth, when adjusting for the net change of $1.1 million in revenue associated with Cypher increased 17% from the year ago period. We delivered solid bottomline results during the quarter with operating income of $4.8 million.

On a non-GAAP basis operating income was $4.6 million, up 55% from the prior year. Non-GAAP operating margin was 33%, up 800 basis points compared with the prior year period, driven by the strength of the Cordis revenue performance.

On a GAAP basis, our diluted earnings per share was $0.18 for the third quarter compared to diluted earnings per share of $0.17 from the year ago period. Excluding the impact of Cypher non-GAAP diluted earnings per share in the third quarter grew 42%, and was $0.17 compared to non-GAAP diluted earnings per share of $0.12 from the year ago period.

I will now turn our discussion to performance by business unit. For the third quarter, Medical Device sales, which include revenue from both our hydrophilic coatings and device drug delivery technologies totaled $10.3 million, up 7% from the $9.6 million reported in the year ago period. Excluding Cypher, Medical Device revenue grew 22%.

Third quarter results include hydrophilic coatings revenue of $10 million, which was up 18% compared with the year ago period. Hydrophilic coatings revenue growth was broad based with strong growth in each of our revenue lines.

Notably, we continue to see strong growth in our research and development revenue, which nearly doubled from the year ago period. Driving this performance was an increase in the number of Medical Device customers, leveraging our coating services to support their pre-clinical, clinical and commercial activities.

These research and development activities may lead to future royalty revenue. We continue to see strong double-digit royalty revenue growth in key Medical Device market segments, including neurovascular, peripheral and transcatheter heart valve repair and replacement.

During the quarter, we saw a return to royalty growth in the Coronary and Cardiac Rhythm Management market segment. After a 9% declined in the second quarter, the third quarter generated 5% growth in this market segment when adjusting for Cypher. This growth was primarily driven by recently launched customer products.

Partially offsetting the strong growth in our hydrophilic coating technologies, device drug delivery revenue of $230,000 declined nearly $800,000 from last year's third quarter. This decline was largely attributable to Cypher.

On the bottomline, Medical Device generated $5.2 million of operating income during the quarter, representing a 13% increase from the year ago period. Excluding Cypher, Medical Device operating income grew 32% from the year ago period, driven by higher revenue.

Looking at our In Vitro Diagnostics business unit, our IVD sales for the third quarter totaled $3.7 million, an increase of 7% compared with $3.4 million in the third quarter of fiscal 2011. Our IVD business unit has now generated seven consecutive quarters of year-on-year revenue growth.

We achieved record diagnostic product revenue during the quarter. Our products revenue performance was broad based as we saw growth across most of our key product lines and customer segments.

I'd like to take a moment to provide some insight around this quarter's operating income. IVD generated $1.1 million of operating income during the quarter, down 26% from last year's third quarter.

IVD operating income was affected by a $650,000 increase in product cost from the year ago period. We anticipate that our IVD business unit will see a return to more normal operating margins going forward.

Now, let's discuss our revenue summary by category. Royalty and license fees, which are generated primarily in our Medical Device business unit were $7.1 million, down 5% from the $7.5 million reported last year. Excluding the impact of Cypher, royalty and license fees grew 11% in the third quarter of fiscal 2012.

Product sales of $5.7 million grew 15% from the year ago period. Broad based product revenue growth was seen in the quarter with hydrophilic coating reagent growing double digits and IVD product sales growing in the high single digit.

Lastly, R&D revenue in the third quarter was $1.1, and doubling from the $550,000 reported last year. Coating services support for certain of our hydrophilic customers drove the increase in R&D revenue.

Moving on, we generated product gross margins of 61% in the third quarter of fiscal 2012 compared with 74% last year. However, when looking at the year-over-year comparison it is worth noting that our fiscal 2011 third quarter product margin was highest seen in either fiscal 2011 or fiscal 2012. In the third quarter of fiscal 2012, we had increased product cost, which negatively impacted margins.

Other recent quarters have seen product gross margins range betweens 64% to 68%. Going forward, we expect that are product gross margins will return to our normal historical range. Reviewing operating margins, third quarter of fiscal 2012 operating margins were 34% compared with 33% last year.

SG&A expenses for the third quarter of fiscal 2012 were 24% of revenue compared with 27% in the year ago period. SG&A expenses declined 3% from last year, mainly as a result of last year's cost reduction efforts.

Research and development expenses were 25% of third quarter revenue compared with 30% in the third quarter of fiscal 2011. R&D expenses declined 10% from the year ago period, as result of last year's productivity and cost actions.

Taking a quick review of our balance sheet, our cash and investments totaled $108.2 million. We continue to generate solid cash flow during the quarter. Cash flow from operations was $5.8 million during the third quarter.

Management and the board regularly evaluate the use of our cash, and in just a moment Gary will provide an update on our plan to commence a tender offer to repurchase up to $55 million of our common stock. This tender offer is a fully subscribed, represents a return of approximately half of our total cash and investments to shareholders.

Finally, turning to guidance. As you saw in our press release, we've increased our revenue and earnings per share outlook for the full fiscal year 2012, as a result of our strong year-to-date performance. It is important to note that our outlook excludes any share count reduction and expenses associated with our planned self tender share repurchase.

Revenue from continuing operation for fiscal 2012 is now expected to be in the range of $51 million to $52 million, above our initial guidance of $47 million to $51 million. Diluted earnings per share from continuing operation is now expect to be in the range of $0.56 to $0.59 per share, above our initial guidance of $0.45 to $0.53 per share. Our outlook is based on a diluted share count of 17.6 million shares.

At this point, I would like to turn the call over to our Chief Executive Officer, Gary Maharaj.

Gary Maharaj

Thank you, Tim. I'm pleased that our reported financial results demonstrate the continued execution of our over-watching goal to return SurModics to profitable growth. Our most recent results and corresponding positive momentum that we have generated over the course of this fiscal year is result of our strategic objectives and a testament to the efforts of our talented team of employees that have taken up this charge.

While we are proud of our recent accomplishments this quarter, rest assured that we will not be satisfied with only near-term progress. Our team's mindset here at SurModics is to ensure that we establish this type of performance as an ongoing consistent result. We remain as vigilant about ongoing goal to build a great organization as an industry leader, deliver strong results and has high impact in the markets that we serve.

In keep with the theme that we set out at the beginning of this fiscal year two, as I call it of SurModics' transformation, will continue to be defined by the following three areas: first, a focus in our ability to drive our core business to generate profitable growth and cash flow; second, discovery in R&D to drive organic growth and optimize long-term returns from more product development pipeline; and third, to define our strategy for use of cash on the balance sheet.

Let's review each of these strategic priorities in more detailed. First, our ability to profitability expand our core businesses to generate long-term growth. In the Medical Device business unit, our co-initiatives leave us well positioned in the fast growing area such as transcatheter valves, peripheral vascular applications. And we expect to see it become even more relevant to our revenues during the next year.

In the third quarter, as Tim said, we saw record quarterly hydrophilic coating revenue. And in addition, three Medical Device customers launched new products that license our hydrophilic coatings technology.

The number of feasibility studies with our next-generation hydrophilics coatings platforms, what I'd refer to as Gen 5, continues to increase. Gen 5 as you'll recall provide the same low friction capabilities expected from prior generations of SurModics' hydrophilics coatings and provides enhanced durability for multiple vascular applications. We are continuing to invest and expanding the capabilities of Gen 5 to the many variations of multiple substrate materials that exist in even more challenging applications.

In our IVD business unit, we continue to execute on our plan to create organic growth in our core business. These plans include adding new diagnostic test customers, increasing our sales of current products to existing customers and launching new products.

It pleases me to note that that business has now achieved seven consecutive quarter of year-on-year revenue growth. In fact during the last quarter, we gained six new diagnostic kit customers, who order our products as components to their kits. We feel really good about our progress we have made and opportunity we see across both these core businesses.

Our second area of focus that is part of our long-term growth strategy and helps (a failure 6-0.16) to is R&D. In Medical Devices, we have had two key areas of focus pertaining to R&D. As I have described earlier our Gen 5 hydrophilic coating and second our drug-coated balloon project.

During the past three months on our drug-coated balloon project, we have focused on optimizing the coating application process to improve the consistency and effectiveness of drug delivery and tissue uptake. Our aim is to offer our customers a consistent coating with a predictable target tissue uptake characteristic by minimizing unintended drug loss in the vascular tube. We remain very excited about our drug-coated balloon efforts and embrace the challenges inherent and the development of such a platform.

In July, our IVD business unit launched yet another product. This time in our BioFX colorimetric substrates line call BioFX TMBX, which improves both the dynamic range and the reproducibility of certain quantitative assays. This is a second product launch in fiscal 2012 by our IVD team.

Finally, let's talk about the third strategic area of focus that defines our year. The appropriate deployment of the cash on our balance sheet to create shareholder value. If you recall, last quarter we announced the authorization to repurchase up to $50 million of shares, with the details of the repurchase to be announce at a later date. Including the amount remaining under previously approved share repurchase authorization, we are now authorized to repurchase up to $55 million of our common stock.

Our objective here is to strike the right balance between continuing to fund the organic growth through investments in our R&D pipeline, while maintaining the financial flexibility to be both optimistic and manage risk while returning excess cash to shareholders.

Today, we are pleased to announce that our board of directors has authorized a modified Dutch auction tender process offer to repurchase up to $55 million of the company's common stock. This tender offer is expect to commence on or about Monday, August 06, 2012. And the details related to the tender offer will be set forth in our offer to purchase to be filed with the SEC.

The size of the standard offer represents more than 50% of our balance sheet cash. It demonstrates our commitment towards distributing value by returning excess cash to our shareholders.

In conjunction with our board, we will continue to evaluate the appropriate balance of three users of cash. Cash deployment to create value, cash returned to shareholder to redistribute value and cash reserves of both opportunistic investments and to manage risk.

In summary, we continue to make progress against and generate excitement around the three critical areas that we have defined as part of our transformational growth strategy, growth from our core products, our R&D opportunities, and finally the strategic and disciplined use of cash to create return and protect value for all shareholders.

We firmly believe that our commitment to executing against these key strategic objectives will continue to position the company to achieve our goal of delivering sustainable long-term double-digit growth.

Operator, this concludes our prepared remarks. We'd like now to open the call to questions. Thank you.

Question-and-Answer Session


(Operator Instructions) Our first question comes from the line of Ross Taylor with C.L. King.

Ross Taylor - C.L. King

Maybe just a couple of financial questions. But within the product cost of $650,000 amounts to all identified. Could you give any color as to what that is or why your company rose this quarter? And my other question related to the financials is the royalty and license fee revenue amount, I just wondered if that included just sort of any unusual or I guess excisable license fee in the quarter?

Tim Arens

With regard to product cost in the quarter, looking at it from a year-on-year perspective, one thing to keep in mind is that the product revenue increased about $750,000 from the year ago period. So a good portion of the increase in product cost came from increased product revenue. So that's part of it. Part of the other incremental increases in the product cost rising would be scrap and product mix. So those are some of your primary drivers.

Ross Taylor - C.L. King

And then on the question about the royalties and the license fees?

Tin Arens

No. There are no unique license fees or royalties that were large or non-recurring or potential that'd be recurring in the Q3 of fiscal 2012.

Ross Taylor - CL King

And maybe just two or three other quick questions. The increase in R&D revenue, this the reflection of your uptake or high interest levels in your Gen 5 coating?

Gary Maharaj

Ross, this is more about a lot of the customers are going through clinical development or to commercialization looking to leverage our expertise to quote to help them get to market faster. It's just something that we've been putting more energy and effort and focus on. It's not driven by Gen 5.

Ross Taylor - C.L. King

My last question, drug-eluting balloon, you mentioned now that lot of your focus there is on the coating process. Does that suggest you're content with the science behind the coating you developed and the allusion properties that has and the kind of the results you've seen in pre-clinical studies?

Tim Arens

What I would characterize it as is, it is a very tight coupling between small variations and application process and the consistency and tissue uptake. And then so what we'd like to do is as we've have looked at some of the other products in the market, one of the things we like to use as element is really consistency and so they are very much coupled together.

So I wouldn't see you have a stable platform in the drug delivery. And then you see really focused afterwards on the application process. They're both finding as they're both very intimately connected. So it's become the circular feedback loop where you have to address one to ensure the other.


And your next question comes from the line of Beth Lilly with GAMCO Investors.

Beth Lilly - GAMCO Investors

I have one question, the Modified Dutch Tender. Can you talk about what exactly that means? I mean there no price range given. So what happens on August 6?

Tim Arens

You are right. There is no price range at this point. We're just announcing our intention implement the Dutch Tender. On or around the 6, you will see more detailed around the conditions and terms including the price range. So we'll just ask people to wait until, on or about the 6 and they'll have insight and information with regards to pricing on the tender.

Beth Lilly - GAMCO Investors

Can you just help to provide a little insight in why you didn't named the price range today, as opposed to waiting until the 6?

Tim Arens

Really the main reason here is we've had really quite honestly a very good quarter. We've increased our outlook for the year. I think just in terms of setting pricing before letting the market digest this information, we felt that it would be better for us to allow the margin to look at this news and that will help with the pricing.

Beth Lilly - GAMCO Investors

So you'll put out all the terms and condition on the 6?

Tim Arens

On or about the 6, Beth.


Our next question comes from the line of Gregory Macosko with Lord Abbett

Gregory Macosko - Lord Abbett

With regard to your expectations for the rest of 2012, looking forward the increase is nice and into the topline, but its relatively modest to kind of how you've done in the second quarter? Give us a sense of how you're sizing that $51 million to $52 million?

Tim Arens

The way we look at the range here is really looking at dollar available information, and if you to look at it from a non-GAAP perspective which is the way that we encourage people to also look at the business, certainly look at it from a GAAP perspective but also from a non-GAAP. They're looking at about 5% to 13% revenue growth for the fourth quarter.

If you look at what we've done, so far this year is 13% in Q1, 4% in Q2, and 18% here in Q3. So honestly, we're looking at a revenue growth that's kind of right where we've been at this year. So Q4 really doesn't look much different than what we've generated here for the first nine months of the year.

Gregory Macosko - Lord Abbett

We could question that but never mind. With regard to the 17% adjusted growth on the royalties and licensing, is that volume driven just in terms the people that have the license and the royalties. Is it because of the volume of their products and there uses of it was up. Is that really, what's the driver there?

Gary Maharaj

As we've described here, we're seeing really nice growth in some of the high growing market segments within med device. We've seen double-digit royalty revenue growth in all three of these segments, transcatheter heart valves as well as peripheral vascular and neuro. Those applications are somewhat newer notes. Customers who wants price in the past and are continuing to see adoption of there products, benefits us.

Gregory Macosko - Lord Abbett

And then finally with regards to the in vitro diagnostic, is there a kind of a stabilization level that you perceive relative to the operating profit there with regard to the revenues were up with the profit, the operating profit was down. Is there a point at which when we look forward that product cost et cetera will stabilize?

Tim Arens

Yes, in fact I would encourage people to think that our product cost for Q4 and our product gross margins will look awfully lot like what we've seen here in Q1, Q2 time horizon. You're going to watching at operating margins for the diagnostic business that will be around 30% plus or minus, couple of hundred basis points. So what we've seen here in Q3, is what I would term to be kind of an outlier.

Gregory Macosko - Lord Abbett

So that 30% as we look forward, is at least the starting point for where you're seeing it?

Tim Arens

That's right.


Over next question comes from the line of Jeffrey Warshauer with Sidoti & Company.

Jeffrey Warshauer - Sidoti & Company

When you talk about market opportunity in the medical device space, you talked about in-house device versus uncoated devices. Can you maybe just give a little more color of where you see traction in each of those, this past quarter and going forward?

Gary Maharaj

Certainly, so keep in mind what we called coatings that are done in-house are also is an overlap because a lot of these customers use SurModics hydrophilic coatings on some products, but perhaps not on some of there high volume products. So they're once a customer as well as an opportunity to grow.

And part of that is, we certainly have had early conversations for us and for these customers as we go through the qualification of our Gen 5 platforms on particular substrates that will be more applicable to these customers. Then we'll be in a better position to talk about our adoption process.

So Gen 5 which is superior to the previous generations, is being qualified on certain devices and certain substrates, as we're marching through hold big matrix of devices, substrates and how those devices actually meet from those substrates. We're stepping through very methodologically through that and in-house coatings will be a part of that, but perhaps probably on the tail end of flat March.

Jeffrey Warshauer - Sidoti & Company

Do you think, you see the hydrophilic coatings market growing at a higher pace, and where you see yourself relative to that?

Gary Maharaj

Well, as Tim has described, so the emerging high growth segments of transcatheter valves, neurovascular and peripheral vascular were well-positioned and we continue to mind that with new customers in that area. Certainly, the Coronary segment is a big chunk of it. But as we see new devices in the visibility, we see of unlicensed customer prospects now, what we believe that the all opportunity in the market will continue to grow.

As we have numerous clients through there regulatory and then product development timeline. So the product you asked early about the uncoated devices, we consider that as almost two segments. The devices that clearly today should be coated, but probably in their first generation design in the market haven't been and isn't acknowledged, but they should have a hydrophilic coating.

Then yet another category of devices that have not been historically coated, but that can be improved with the hydrophilic coatings, so we see an option to actually certainly in the uncoated segment, get the devices where there is broad recognition that they should be coated first. They stretch to get devices at a uncoated and that is not a recognition that they should be coated, is a slightly longer timeline.

Tim Arens

I'll just complement on Gary's response here by telling you one other things that has us excited is we're really well positioned in some of these high growing market segments within that device. And I want to people to think about this is the addressable markets are growing.

A great example would be transcatheter valves. Transcatheter valves only recently received the market approval and particular in the U.S. its several quarters ago, and you're starting to see nice up tick in adoption. You're seeing an increase in procedures. As these emerging segments continue to grow and continue to see devices used in these procedures, we benefit and we win.

So part of our growth is going to continue to come from more traditional segments, as those customers continue to bring new products to market, in coronary for example and CRM. But we'll see and will continue to benefit from strong growth in some of the emerging market that would help to increase the addressable markets for us.


(Operator Instructions) Our next question is a follow-up question from the line of Gregory Macosko with Lord Abbett.

Gregory Macosko - Lord Abbett

One final question, with regard to deceive a marketplace out there, have you been looking at any acquisitions and have you had any candidates there, made some bids perhaps and maybe didn't come through or are you in discussions?

Gary Maharaj

We typically would not comment on that. However, we have no acquisitions in line at this point.

Gregory Macosko - Lord Abbett

So in other words, you're not even looking in any direction relative to acquiring something that would be in the coating area.

Tim Arens

We certainly are always vigilant of opportunities under horizon and that's how I'll characterize that.


And we also have a follow-up question from the line of Ross Taylor.

Ross Taylor - C.L. King

Looking at your royalty revenues over the last three quarters, I know sequentially things ticked down a little bit in March and then we've had a big sequential uptick here in the June quarter. And is it new product introductions that are primarily driving the increase in June compared to what we saw in March or was it a recovery of the overall portfolio. I was just wondering if you could give any color on that.

Gary Maharaj

So there are several things that are driving that. And so just for the benefit of others, Ross, I'd believe you're referring to what we'd consider the adjusted for Cypher royalties, and so the way for folks to think about this is we benefited from new products being introduced. So a really clear and good example of that would be Medtronic's recent introduction of its latest Drug-Eluting Stent which happened a little over quarter ago.

So we get continue to see other customers watch new products in the coronary spaces as well as in the other spaces that we just commented on earlier.

But I want to draw back on to that previous answer which is, we're seeing real nice growth in these emerging growth segments and the addressable market is increasing. And that trend to see more procedures and more devices used to treat patients in neuro applications, peripheral applications as well as transcatheter applications, transcatheter heart valve and repair applications has really benefited us.

So that's where you're seeing some lift and some up tick. And the Coronary and CRM segment did rebound this quarter as well. That's the represented part of it.


Thank you. And there are no further questions in the queue. I'd like to turn the conference back over to management for closing remark.

Gary Maharaj

Thank you everyone. We have continued to build momentum in the third quarter of 2012 with solid performances in our core businesses. We remain steadfast in our commitment to return SurModics to profitability and focused revenue growth in these core businesses.

At the same time, we are compelled to continuing investments in R&D and the new product introductions. And finally, we are pleased to be able to use the strength of our balance sheet and the return of cash to shareholders in the form of a Modified Dutch Auction Tender Offer. I want to thank everyone again for participating in this quarter's conference call. We look forward to providing further updates on next quarter's calls. Thank you.


Thank you, ladies and gentlemen. That concludes the SurModics third quarter 2012 earnings conference call. AT&T would like to thank you for your participation. You may now disconnect.

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